The big liabilities that will make a leveraged buyout of Best Buy Co. Inc. challenging are all of the leases, and they aren't even on the company's balance sheet.

Talk of a leveraged buyout of the company has been in the air since founder Richard Schulze left the board and said he would study options for the more than 20 percent of the common stock he controls. But if the idea is that Schulze would use financial leverage to take control of Best Buy, he's mostly too late.

Best Buy's debt at quarter-end was just $2 billion, and the company has cash and an unused bank line. That's a pretty conservative picture -- until you roll in operating leases for the millions of square feet of stores Best Buy operates. The debt-equivalent value of those leases amounts to $9.45 billion at the end of the most recent quarter, pushing total debt near $11.5 billion.

R.J. Hottovy, the director of consumer cyclical research at Morningstar, said Best Buy's big lease obligations are "often overlooked in this deal."

Bankers and private equity managers in the Twin Cities are well-versed in the role of store leases in past crackups such as Wilsons the Leather Experts Inc., which decided to liquidate in 2008. After talking with these financiers, it seems fair to conclude that most of the new money in any leveraged acquisition of Best Buy would have to come from somebody besides lenders.

How can rent be debt? Well, lenders know that the day a retailer decides a store on a given location can't make money may be many years before the expiration of the lease. Then that lease for a great location, thought of as a wonderful asset as publicity photos were snapping at the grand opening, reveals itself to be nothing but an ugly long-term liability. Sure, a sublet is a possibility, but bankers know that modifying or terminating a valid lease, up to and including threatening the landlord with bankruptcy, usually is all but hopeless.

So banks and other financial institutions take annual rent expense and multiply it by eight, and add that to debt. In calculating cash flow available to repay the obligations, they take earnings and add back expenses such as depreciation and taxes, and then add back the rental expense, to make sure they count rent on both sides of the calculation. That gives them a clearer total debt picture.

Best Buy's total debt load has inched up, from 2.4 times cash flow at the end of last year's first quarter and 2.6 at the end of the last fiscal year to stand at 2.7 as of the first week of May, the end of the current year's first quarter. That's because Best Buy had still been signing up for more lease obligations even as cash flow drifted down to about $4.2 billion for the most recent 12 months.

This is not to suggest that a debt crisis looms, but with its lease commitments Best Buy is today more highly leveraged than many other big publicly held retailers.

The home improvement retailer Lowe's Companies Inc., for example, has a lease-adjusted leverage target of 2.25, and has been well below its target. Management tells its investors that if the leverage ratio falls too low it means they are being too conservative, and so Lowe's may buy back stock to be more efficient with investor capital. If the ratio creeps too high, Lowe's said it will do what it takes to bring down debt and keep investment-grade credit ratings.

Best Buy's debt is already hanging on the very edge of investment grade, with a BBB- rating from Standard and Poor's and Fitch Ratings. "We don't typically specify hard ranges for rating categories as qualitative factors such as market share defensibility and quality and strength of earnings are important considerations," said Monica Aggarwal, who heads Fitch's U.S. retail group. "However, retailers with leverage of over 3.0 [to] 3.5 times will typically be rated noninvestment grade."

And, as Fitch had noted in a recent report, "Best Buy faces headwinds around same-store sales, market share, and competition that are more pronounced than for other retailers with similar leverage."

With that kind of commentary out in the market, walking around midtown Manhattan looking for capital is not an easy task, even with the head start provided by Schulze's own big ownership position. Any Schulze-led group still needs to come up with the money to buy the roughly 80 percent of the stock he does not control.

Valuation assumptions have been all over the map, but published accounts so far this summer suggest any bid would have to be at least in the mid-$30s per share to be taken seriously by Best Buy's board. At $35 per share, a Schulze-led group would need to raise more than $9.5 billion plus even more money to cover fees.

Twin Cities private equity and lender sources say that about the best a new owner in control of Best Buy should expect from banks is just one more "turn" of leverage, taking total debt to cash flow up from 2.7 currently to a ratio of 3.7. That means new borrowing of about $4.2 billion.

At closing, the buyout group would get access to maybe $1 billion of the cash now on the balance sheet. But that still would leave Schulze and his advisers looking for investors to put more than $4.3 billion into a business with declining same-store sales, no permanent CEO, and pressing strategic questions.

Schulze is not making himself available to discuss his plans, but the market price of Best Buy's shares pops periodically on talk that he is about to propose terms. Recently that price has drifted down to less than $19 as there has been no further word from him. Perhaps he will make some statement by Aug. 1.

Lee Schafer came to the Star Tribune after 15 years as a corporate officer, consultant and investment banker in the Twin Cities. He has been a columnist for Twin Cities Business magazine and was senior editor for Corporate Report Minnesota. Follow @LeeASchafer

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